Question

Question 3 Dahmen plc is financed by 60% debt and 40% equity. Dahmen would like to determine their weighted-average cost of capital (WACC) so this can be used to appraise their potential capital investment projects.

(a) Describe the WACC. (4 marks, maximum 200 words)

You have been provided with the following information to allow you to determine Dahmen’s WACC

• Dahmen’s bond holders have a required yield of 9%

• Dahmen’s ordinary shares are currently priced at $40.

• The latest dividend of $4 per share has just been paid.

• The dividend growth rate over the past few years has been 8% and this is expected to continue for the foreseeable future.

• Dahmen’s corporation tax rate is 35%.

(b) Calculate Dahmen’s WACC.

Total for the question 10 marks

Answer 1

1.Weighted average cost of capital (WACC) is a benchmark for internal rate of return. It helps to determine if it is profitable to undertake a project.

The cost of equity is calculated using the dividend discount model. It is calculated using the below formula:

Ke=D1/Po+g

where:

D1= Next year’s dividend

Po=Current stock price

g=Firm’s growth rate

Ke= Required rate of return on equity

Ke= $4*(1 + 0.08)/ $40 + 0.08

= $4.32/ $40 + 0.08

= 0.1080 + 0.08

= 0.1880*100

= 18.80%.

WACC is calculated by using the formula below:

WACC= wd*kd(1-t)+we*ke

Where:

Wd=percentage of debt in the capital structure

We=percentage of equity in the capital structure

Kd=cost of debt

Ke=cost of equity

t= tax rate

WACC= 0.60*9%*(1 - 0.35) + 0.40*18.80%

= 0.60*5.85% + 0.40*18.80%

= 3.51% + 7.52%

= 11.03%.